Another financial product rant

As I sit down to write another article, Great Southern has just collapsed and I have been asked to speak to some Financial Planners about structured products. If the Global Financial Crisis has taught us anything or confirmed what we already know, it’s that we must avoid investing in anything we don’t understand and avoid high commission or high fee charging investment products. Unlike other industries, in ours the higher the cost very rarely means you are receiving higher quality as the Agribusiness, Hedge Fund and Structured Products have shown. Each of these sub-asset classes are also not the easiest investments to understand.

Both Timbercorp and Great Southern’s collapse have created enormous anxiety for the investor as there is still significant uncertainty as to what they are likely to receive from their initial investment or where they stand in terms of ongoing commitments. The complexity of these companies’ promises and structures will soon come to light but it appears the administrators are still coming to grips with them also.

Whilst there have been a few hedge fund collapses and closures, the current bear market has exposed them as funds that still have exposure to market risks, whether credit, equities, bonds, etc. and that their promise of positive returns in any market was simply a marketing line as the average global hedge fund or main hedge fund indices returned around -20% for the 2008 year. When you add their lack of liquidity and, for some, their recent suspension, compared to the more traditional managed funds their performance is even more disappointing.

Finally we have the structured products that promise capital protection or limited losses whilst still providing the investors exposure to the performance potential of various sharemarkets. In terms of complexity and hidden fees, structured products may well take the prize.

There is one particularly product I have reviewed in recent weeks that I find astonishing. I’m even more astonished that it received the second highest rating from one of Australia’s leading research houses. In its most conservative form (in terms of maximum loss), at first read, for an investment of around $6,000 the investor will receive $50,000 exposure to the Australian sharemarket (ASX200) and after 2 years receives a maximum return of $9,250 (or ~18.5% of the $50000 exposure) and at worst, nothing (if the ASX200 has a zero or negative performance over the 2 years).

For many prospective investors this type of investment may sound quite appealing, particularly if bullish on the ASX200 index, as only an 18.5% return over 2 years is required to be what appears to be a return of more than 150% on the initial investment. Unfortunately, in this case, looks are very deceiving.

Firstly, the $6,000 investment is in fact a payment for an options position (as opposed to an initial investment) and can only be recovered if the ASX200 returns 12% over the 2 years (i.e. 12% of $50,000 equals $6,000). The options position being purchased is the purchase of one call option with a strike price of $50,000 and selling another call option with a strike price of $59,250 that matures in 2 years.

Secondly, because the exposure is the ASX200 index and not the ASX200 Accumulation index, the investor receives no exposure to dividends, let alone franked dividends. Given the current dividend yield of the Australian sharemarket is around 7%, if we assume a conservative forward dividend yield of 5%, then just to get your initial investment back, the ASX200 (including dividends) needs to return 11% (that is, 6% capital growth plus the 5% dividend).

Over the last 25 years, the ASX200 Accumulation Index has returned just over 9% and over 25 years, 10.93%. If we look at the index in question, the ASX200 Share Price Index, its 20 year performance is approximately 4.6% and over 25 years is 6.45%. So what initially may have appeared an attractive structured product in fact requires above average returns just to get your money back.

I have never seen more demand for structured products than now. Unfortunately, many of these are simply fee grabs by the investment banks who issue them as they take advantage of the risk aversion many investors now have after suffering significant sharemarket losses. I urge all adviser take significant care when looking at structured products. For most investors they would probably be better off investing in a simple well-diversified fund with a 50/50 split between growth and defensive assets…don’t forget this structure also has limited downside whilst providing sharemarket exposure.